Unit 7: Cost of Capital - Practice Quiz

1 What does a company's cost of capital represent?

2 Why is the cost of capital commonly used in investment decisions?

3 Which financing sources are generally included in a firm's overall cost of capital?

4 What is the cost of debt before tax primarily based on?

5 If the before-tax cost of debt is and the tax rate is , what is the after-tax cost of debt?

6 Why is the after-tax cost of debt usually lower than the before-tax cost?

7 What does the cost of equity represent?

8 Under the dividend growth model, which formula estimates the cost of equity?

9 In the Capital Asset Pricing Model, what does beta measure?

10 Which return is the starting point in the Capital Asset Pricing Model?

11 What are retained earnings?

12 Why do retained earnings have a cost?

13 Compared with newly issued equity, retained earnings generally avoid which cost?

14 What does WACC stand for?

15 A company is financed equally by debt and equity. If the after-tax debt cost is and the equity cost is , what is its WACC?

16 Which values are generally preferred when determining the financing weights in WACC?

17 A firm's capital is debt and equity. If the after-tax debt cost is and the equity cost is , what is its WACC?

18 Which additional risk commonly affects the cost of capital for an international investment?

19 What does country risk refer to in international finance?

20 How may high political uncertainty in a foreign country affect a project's required return?

21 Which cost of capital is most relevant when evaluating whether to accept a new investment project?

22 A company uses the same discount rate for every proposed project, although the projects have substantially different business risks. What is the main weakness of this policy?

23 A project has an expected return of , while its risk-adjusted required return is . Based only on the cost-of-capital criterion, what should the company do?

24 A company issues five-year bonds with a face value of , an annual coupon of , and net proceeds of . Using the approximate yield formula, what is the before-tax cost of debt?

25 An irredeemable bond pays annual interest of , has a market price of , and faces a corporate tax rate of . What is its after-tax cost of debt?

26 A company issues irredeemable debt with a face value of but receives only after flotation costs. If the tax rate is , what is the after-tax cost?

27 A firm's existing bonds trade below face value because market interest rates have increased. Which measure best estimates the current before-tax cost of this debt?

28 The risk-free rate is , the expected market return is , and a company's equity beta is . According to CAPM, what is its cost of equity?

29 A share sells for . The dividend expected next year is , and dividends are expected to grow at annually. What is the cost of equity under the constant-growth dividend model?

30 A company plans a new share issue at per share and expects flotation costs equal to of the issue price. If the next dividend is and growth is , what is the cost of new equity?

31 Two companies have identical expected dividends and growth, but Company X has greater systematic risk. Under CAPM, how should Company X's cost of equity compare with that of the other company?

32 Why do retained earnings have a cost even though the company does not pay flotation fees to retain them?

33 A company's next expected dividend is , its share price is , and its expected growth rate is . Using the dividend-growth approach without personal-tax adjustments, what is the cost of retained earnings?

34 A firm has market-value debt of million and equity of million. The after-tax cost of debt is , and the cost of equity is . What is its WACC?

35 A firm's financing consists of debt, preference shares, and equity by market value. Their respective costs are , , and . What is the WACC?

36 A company is financed with debt and equity. Its before-tax debt cost is , its equity cost is , and its tax rate is . What is its WACC?

37 A firm's book-value debt-to-equity ratio differs substantially from its market-value ratio. Which weights should generally be used to calculate WACC for investment decisions?

38 A company with a WACC of is evaluating a project that is significantly riskier than its existing operations. Which discount-rate treatment is most appropriate?

39 A company evaluates a foreign project exposed to material country risk not captured by its domestic WACC. Which adjustment is generally appropriate?

40 How can greater integration with international capital markets potentially reduce a multinational company's cost of equity?

41 A firm issued long-term debt five years ago at a 5% yield. Comparable debt now yields 8%, while the firm's accounting records continue to report a 5% interest cost. Which rate is relevant when estimating the current cost of capital?

42 A project's cash flows are forecast in real terms. The firm's nominal WACC is 10.30%, and expected inflation is 3.00%. Assuming consistent inflation expectations, which discount rate should be applied?

43 A low-risk project will initially be funded entirely with debt, although the firm maintains a long-run target debt-equity ratio. Which hurdle-rate approach is conceptually appropriate?

44 A firm can borrow at 8%. Its statutory corporate tax rate is 30%, but interest-limitation rules make only 40% of incremental interest deductible. What is the effective after-tax cost of debt?

45 A five-year bond has a face value of $1,000, pays a 6% annual coupon, and provides net issue proceeds of $950. It is redeemed at par, and the corporate tax rate is 25%. What is its approximate after-tax cost?

46 A firm issues perpetual debt with a 7% coupon on a face value of $1,000. Flotation costs equal 2% of face value, and interest is fully deductible at a 30% tax rate. What is the after-tax cost of the new debt?

47 A comparable unlevered business has an asset beta of 0.90. A project will maintain a debt-equity ratio of 0.60, debt beta is zero, and the tax rate is 25%. If the risk-free rate is 4% and the market risk premium is 6%, what is the project's cost of equity?

48 A company expects a dividend of $3 per share next year, its shares sell for $40, and dividends should grow perpetually at 4%. New shares incur flotation costs equal to 5% of the market price. What is the cost of new equity?

49 A pure-play comparable has an equity beta of 1.40, a debt-equity ratio of 0.80, and a tax rate of 25%. A project will use a debt-equity ratio of 0.30. Assuming risk-free debt, a 3% risk-free rate, and a 6% market risk premium, what is the project's cost of equity?

50 A firm's shareholders require a 13% return on investments with the risk of its existing operations. The firm has sufficient retained earnings and incurs no issuance costs by retaining them. Ignoring personal taxes, what is the cost of retained earnings?

51 Under a shareholder-opportunity-cost model, distributing $1 of earnings would trigger a 20% personal dividend tax, after which brokerage costs would consume 2% of the investable amount. If shareholders can earn 12% on equivalent-risk investments, what is the implied cost of retaining the $1?

52 A firm can reinvest retained earnings in a project expected to return 9%. Shareholders can earn 12% on equivalent-risk investments, with no taxes or transaction costs. Which decision is consistent with shareholder wealth maximization?

53 A company has 2 million shares trading at $30, bonds with a $50 million book value trading at 90% of par, and preferred shares worth $12 million in the market. The costs of equity, pre-tax debt, and preferred stock are 12%, 7%, and 9%, respectively. If the tax rate is 25%, what is the WACC?

54 A firm targets 60% equity and 40% debt. It has $12 million of retained earnings costing 11%; new equity costs 12.5%, and after-tax debt costs 6%. If it raises $24 million while maintaining target weights, what is the average financing cost across the entire amount?

55 A firm finances a representative project with 50% common equity, 40% debt, and 10% preferred stock. Equity costs 13%, debt costs 8% before a 25% tax, and preferred stock pays a $9 dividend while providing net proceeds of $95. What is the WACC?

56 A loss-making firm expects no usable interest tax shields during a project's life, and the valuation assigns no terminal value to those shields. Its pre-tax debt cost is 7%, equity cost is 11%, and market-value weights are 40% debt and 60% equity. What WACC is appropriate?

57 A project's Brazilian-real cash flows incorporate 6% expected Brazilian inflation. The comparable nominal US-dollar cost of capital is 8%, and expected US inflation is 2%. Under relative purchasing power parity, what real-denominated nominal discount rate is consistent with the cash flows?

58 For an overseas project, the global risk-free rate is 3%, the global market risk premium is 5%, the project beta is 1.10, the sovereign spread is 4%, and the project's exposure coefficient to country risk is 0.75. Using an adjusted CAPM, what is the cost of equity?

59 A foreign subsidiary borrows at 10%. Local rules permit deduction of only 80% of interest, the local corporate tax rate is 25%, and a 5% withholding tax on gross interest is borne by the borrower. What is the effective debt cost before considering exchange-rate changes?

60 A multinational evaluates a project in a financially integrated country. Country risk has already been incorporated into scenario cash flows. Which equity-cost estimate best avoids double counting risk?